ESG CASE STUDY OCTOBER 2014 U.S. Oil & Gas Exploration & Production The controversy surrounding [the E&P] industry has led to widely varying approaches to investing in these stocks. In recent years the U.S. exploration and production (E&P) industry has been a hot-button area. Independent E&P companies have led a dramatic resurgence in domestic oil and gas (O&G) production, potentially putting the U.S. on a path to energy independence. The combination of declining conventional O&G resources and the use of hydraulic fracturing ( fracking ) to open up vast shale resources has led to a new O&G boom in the U.S. While reduced dependence on foreign oil is positive, the rapid growth in O&G development has come with some negative side effects, largely related to environmental impact. The tremendous growth witnessed over the last few years in places like North Dakota and Texas has resulted in O&G companies operating much closer to communities, often literally in some people s backyards. The controversy surrounding this industry has led to widely varying approaches to investing in these stocks. Some investors choose to emphasize E&Ps in portfolios while others divest from the industry completely. This dichotomy makes the E&P industry an interesting and timely example for a case study. At F.L.Putnam our research process always starts with the fundamentals of individual stocks, their industries and associated trends. As we narrow the list of potential investment ideas we dig into the ESG and SRI factors most relevant to specific industries and companies and review quantitative ESG data to help put our work in context with the broader peer group. Our portfolio managers use our fundamental and ESG research along with client specific investment policies to craft customized portfolios tailored to each client s needs. E&P INDUSTRY CASE STUDY - 1
Spills and Leaks Minimizing Emissions Water Use and Handling Fracking Management Community Engagement Corporate Governance For the E&P industry, environmental issues take center stage given the inherent risk O&G development poses to the environment and the risk of increased liabilities and operating costs when accidents are not well handled. Key Considerations When Evaluating E&Ps When considering an investment in the E&P industry, we start with a thorough review of industry and company fundamentals. From an industry perspective we consider factors affecting O&G prices, government regulations affecting production and transportation, and advances in technology that affect reserve development. From a company perspective we evaluate historical exploration track record, quality and mix of O&G reserves, production growth potential, efficiency of operations, and ability to fund operations from cash flow, among other critical aspects of E&P operations. After narrowing the field as described above, we evaluate company performance on key ESG factors relevant to the industry. For the E&P industry, environmental issues take center stage given the inherent risk O&G development poses to the environment and the risk of increased liabilities and operating costs when accidents are not well handled. There are three primary areas of concern: spills or leaks of hydrocarbons; systems and infrastructure in place to capture gas; and water use and handling. Additionally, many investors are concerned about the widespread use of fracking, a well stimulation technique that uses large volumes of water, sand and a mix of chemicals to fracture O&G shale formations. Consideration is also given to community engagement efforts and corporate governance issues. EOG Resources Case Study Example: EOG Resources 1 One company that stands out on both the fundamental and ESG factors noted above is EOG Resources. Based on our research, we believe that EOG is a disciplined operator with a management team that takes environmental, health and safety risks quite seriously, making the company an interesting example to use in our case study. 1. Disclosures are an integral part of this presentation. Please see Disclosures on Page 10 E&P INDUSTRY CASE STUDY - 2
Spills and Leaks Minimizing Emissions Water Use and Handling Fracking Management Community Engagement Corporate Governance The complexity involved in drilling shale wells exposes operators to environmental risks throughout the resource development process. Spill & Leak Management & Prevention O&G operations can have a significant impact on the environment in a number of ways, with none more visible and devastating than a release of oil or gas into the surrounding ecosystem. The complexity involved in drilling shale wells exposes operators to environmental risks throughout the resource development process, making health, safety and environmental policies an important component to consider when evaluating E&P operations. EOG has a detailed health, safety and environmental policy that is integral to its operations. The policy guides ongoing employee training with the aim of minimizing operating incidents in the field and ensuring that employees are able to handle effectively any problems that do occur. EOG has not reported any material spills in recent years despite significant growth in the company s operations. The minor surface spills that have occurred thus far have been well contained and led to little environmental impact, due to proper well site construction and effective spill response efforts. While surface procedures and operations are important determinants of environmental performance, the ability to prevent subsurface leaks is equally important. State regulations currently govern the casing of O&G wells, a procedure involving the placement of steel tubing and an outer cement lining around well bores. When properly executed, well casings provide a barrier between the wellstream and the subsurface environment. Well casings that are not sealed properly can lead to leakage from the wellstream into subsurface formations, such as aquifers, potentially contaminating groundwater. EOG tests the casing integrity of every well before performing well completion techniques such as fracking. EOG s commitment to rigorous testing procedures provides some evidence that the company takes environmental performance seriously, an important consideration as we wait for federal regulations to take shape. Well Casing wri.eas.cornell.edu E&P INDUSTRY CASE STUDY - 3
Spills and Leaks Minimizing Emissions Water Use and Handling Fracking Management Community Engagement Corporate Governance Natural gas produced from O&G wells is composed primarily of methane, a greenhouse gas that is roughly 20 times more efficient at trapping radiation compared to carbon dioxide. Minimizing Emissions Most O&G wells produce some combination of liquids and gasses, with the mix varying by drilling location. Natural gas produced from O&G wells is composed primarily of methane, a greenhouse gas that is roughly 20 times more efficient at trapping radiation compared to carbon dioxide. According to the U.S. EPA, 29% of U.S. methane emissions emanate from O&G development, production, transportation and storage. The significant increase in O&G production over the last few years, especially in areas with limited infrastructure has led to growing concerns related to methane emissions. While the E&P industry in aggregate has a long way to go in efforts to address methane emissions, EOG has proven to be an industry leader in addressing this issue. The company has taken a number of steps recently to capture and transport gas from production operations and associated infrastructure. At well sites, EOG uses equipment such as closed-loop venting and portable recovery and processing systems to capture the gas produced when wells are initially completed. The company also uses vapor recovery systems on storage infrastructure. To ensure effective transportation of this associated gas, EOG has installed over 700 miles of gas gathering lines over the past two years. This investment in infrastructure has helped EOG significantly reduce fugitive methane emissions and flaring intensity. vapor recovery oil & gas infrastructure www.hy-bon.com gas gathering system www.e-education.psu.edu Oil & Gas flaring www.oilandgasbuyer.com E&P INDUSTRY CASE STUDY - 4
Spills and Leaks Minimizing Emissions Water Use and Handling Fracking Management Community Engagement Corporate Governance U.S. E&Ps must carefully manage water sourcing, usage of water in the development process and disposal of waste water. Water Usage and Handling Water resource management has become a critical issue in the U.S. E&P industry as the use of fracking has become widespread. A typical frack job on a well can use more than five million gallons of water, with 15% to 80% recovered depending on the well site. U.S. E&Ps must carefully manage water sourcing, usage of water in the development process and disposal of waste water. EOG has operations in a number of significant shale basins in the U.S., covering parts of Texas, Oklahoma, Wyoming and North Dakota, among other states. The company has a water management policy that details operating procedures covering the full life cycle of water used in company operations across different regions of the country. EOG has made considerable progress in sourcing non-potable water in many regions. Strict well integrity testing helps to ensure that water used in the drilling and completion process does not come into contact with groundwater near the surface. After wells are stimulated, produced water returning to the surface is in many cases handled on liners to prevent any spills or leaks from contaminating the surrounding environment. Encouragingly, EOG is making significant progress toward recycling water for reuse, reducing demand for water from existing sources and cutting the associated truck traffic to and from well sites. Recycling efforts are becoming increasingly important in the parts of Texas facing serious drought conditions, so progress here will be important to monitor. water life cycle in oil and gas development www2.epa.gov water life cycle in oil and gas development www.bp.com E&P INDUSTRY CASE STUDY - 5
Spills and Leaks Minimizing Emissions Water Use and Handling Fracking Management Community Engagement Corporate Governance Fracking is currently being used by all publicly traded U.S.-based E&Ps and is under scrutiny given controversies related to water usage, potential groundwater contamination, and community and land impact from well site construction. Hydraulic Fracturing or Fracking Fracking is currently being used by all publicly traded U.S.-based E&Ps to some degree and is under scrutiny given controversies related to water usage, potential groundwater contamination, and community and land impact from well site construction. Fracking is a well stimulation or completion process that involves forcing large volumes of water mixed with sand and chemicals into wells in order to break up shale rock below the surface. Frack fluid is forced through the wellbore at high pressure, traveling thousands of feet below the surface into the horizontal portion of the well. High pressure fluid fractures the rock at various stages through the target zone, with the sand holding the cracks open. Once the frack job is complete, subsurface pressure forces most of the fracturing fluid back to the surface where it is stored for disposal or recycling. Currently the fracking process is loosely regulated by a patchwork of state regulations and federal water discharge programs. The U.S. Environmental Protection Agency (EPA) is working on a comprehensive evaluation of the fracking process and its potential impact on drinking water, with a final report due in 2016. With EPA analysis and federal regulations at least two years away, we believe companies with effective health, safety and environmental policies and strong operational track records like EOG are best positioned to manage fracking-related risks. hydraulic fracturing www.commodityclub.ch E&P INDUSTRY CASE STUDY - 6
Spills and Leaks Minimizing Emissions Water Use and Handling Fracking Management Community Engagement Corporate Governance... company efforts to communicate with land owners and community groups have become increasingly important. Community Engagement Efforts As oil and gas operations increasingly come into closer contact with local communities, company efforts to communicate with land owners and community groups have become increasingly important. EOG has addressed community engagement efforts in corporate responsibility documents, indicating that the company actively engages with community groups and elected officials to discuss potential impacts arising from company operations. In addition to proactive community engagement, EOG has a business conduct and ethics hotline. Calls into the hotline are tracked by a compliance committee, which reports at least annually to the board of directors. Corporate Governance A clear understanding of ownership and board structure, executive compensation and accounting practices can help investors minimize governance-related risks. A review of EOG s governance practices, based on available information, reveals no material concerns. The company has a non-classified board, of which over 70% of directors are independent. Both EOG s audit and compensation committees are 100% composed of independent directors. EOG executive and director compensation disclosure is detailed and raises no red flags. Executive bonuses at EOG are heavily tied to shareholder-friendly metrics such as return on capital. Additionally, our research has not uncovered any material concerns related to shareholder rights restrictions or accounting related issues. E&P INDUSTRY CASE STUDY - 7
Quantitative ESG data provides an objective baseline comparison across peer groups and over time. Our Approach Along with our in-house ESG research, we review third-party quantitative ESG data to facilitate peer comparisons and aid in ongoing monitoring. Quantitative ESG data provides an objective baseline comparison across peer groups and over time. We ve worked with our primary third-party data vendor to rank U.S. based E&P companies. EOG currently ranks in the top 30% of U.S. E&Ps on a broad ESG industry score, a position that we believe reflects the company s efforts in recent years to minimize environmental risks and increase transparency. At F.L.Putnam we build and manage customized portfolios based on individual client objectives, risk tolerance, cash flow needs, taxes and ESG/ SRI guidelines. EOG exhibits many of the fundamental characteristics we look for in E&P investments. Companies like EOG are considered for inclusion in non-esg accounts and in accounts of clients sensitive to environmental issues, but willing to invest in best of breed operators. EOG would not be an eligible holding for clients wishing to avoid fossil fuel exposure, or those strictly opposed to the use of fracking. Our portfolio managers use our fundamental and ESG research, along with client-specific investment policies to craft customized portfolios tailored to each client s needs. E&P INDUSTRY CASE STUDY - 8
INVESTMENT MANAGEMENT TEAM JOHN V. CARBERRY President jcarberry@flputnam.com ROBERTSON P. BREED, CFA Sr. Vice President, Portfolio Manager rbreed@flputnam.com STEVEN N. VIOLIN, CFA Sr. Vice President, Portfolio manager sviolin@flputnam.com ELLEN K. HAZEN, CFA Vice President, Portfolio Manager ehazen@flputnam.com About F.L.Putnam F.L.Putnam Investment Management Company is an independent firm that provides a comprehensive range of personalized investment management services. We are registered with the Securities and Exchange Commission under the Investment Advisers Act of 1940. Our offices are located in Wellesley, MA; Portland, ME; and Portsmouth, NH. We have a nationally diversified clientele that includes endowments, foundations, religious organizations and unions as well as individuals and their families. For more information visit www.flputnam.com. D.J. SHAUGHNESSY, CFA Vice President, Portfolio Manager dshaughnessy@flputnam.com SUSANNE STAUFFER Sr. Portfolio Advisor sstauffer@flputnam.com ANDREW B. WETZEL, CFA Vice President, Portfolio Manager Senior Research Analyst awetzel@flputnam.com This case study was prepared by: Andrew B. Wetzel, CFA, Vice President Portfolio Manager / Senior Research Analyst and the F.L.Putnam Investment Management Team MICHELLE M. BUCKLEY Research Analyst mbuckley@flputnam.com WELLESLEY, MA Wellesley Office Park 20 William Street, Suite G40 Wellesley, MA 02481 Tel: 781.235.6323 Toll Free: 800.344.3435 PORTLAND, ME 245 Commercial Street Suite 500 Portland, ME 04101 Tel: 207.775.3197 Toll Free: 800.356.1781 PORTSMOUTH, NH Satellite Office 155 Fleet Street Portsmouth, NH 03801 Tel: 603.766.4971 E&P INDUSTRY CASE STUDY - 9
Disclosures This material provides general information only and should not be considered investment advice or a solicitation. No one should assume that any investments discussed will be suitable or profitable. The information provided should not be deemed a substitute for personalized advice from an investment professional. Information and opinions presented have been obtained or derived from sources we believe reliable, but we cannot guarantee their accuracy or completeness. Opinions represent F.L.Putnam s judgment as of the date of the report and are subject to change without notice. F.L.Putnam may periodically issue reports or have opinions, which are inconsistent with, and reach different conclusions from, this report. This presentation is not an offer to buy or sell, or a solicitation of an offer to buy or sell the securities mentioned. The investments discussed or recommended in this presentation may be unsuitable for some investors depending on their specific investment objectives and financial position. E&P INDUSTRY CASE STUDY - 10